A House of Cards — and a Plain Old House

Chuck Smith: ‘A friend asked me today about ‘Tri-West Investment Club.’ The idea is you give them $1,000 (minimum) for a year and they start paying you 10% a MONTH! And you get a bonus for referring people. With the bonuses, my friend’s friend made a $2,000 return on a $1,000 investment in one year. They claim to invest it in bank debentures. Sounds like a pyramid scheme to me.’

☞ And to me. A classic Ponzi scheme, in which the funds of new investors (not any actual investment activity) are used to pay old investors. A house of cards. It will end badly.

Josh: ‘We are in the position to sell our house and net about $250,000. We want to buy another house at approximately $250,000. Should we do an all cash deal or put a sizable down payment (40, 50, 60%) and invest the rest? And if so where do we invest? We are in our late thirties with two kids entering school.’

☞ Buying your new house for all cash is a wonderfully conservative thing to do, and will leave you that much more for saving that otherwise would have gone to the mortgage (and ‘points’ at closing). It’s also good for your peace of mind, and leaves you plenty of borrowing power for a home equity loan, should you ever need one.

If you have the opportunity to get, say, a 7% fixed rate mortgage, then NOT getting one is the same as investing your money in a completely safe 7% bond. Right? Not having to pay 7% interest is like earning 7% interest.

The questions are, first, what is your true cost of borrowing, after taking the mortgage interest deduction on your taxes? If you were, for example, in the 40% bracket, between federal and local income tax, then your true cost of borrowing (not counting fees) is 7% less 40% – 4.2%.

What if you could turn around and invest $200K in a completely safe “general obligation” municipal bond issued within your state that paid you 5% tax-free?

In theory, you’d be making a small profit on the difference between your 4.2% cost of borrowing and the 5% you were earning after tax.

(The IRS doesn’t allow you to deduct interest on money borrowed to buy tax-free bonds. But especially if the two transactions weren’t closely linked, you could certainly deduct interest on money borrowed to buy a house – even if that did leave you free to invest some of your cash in tax-free bonds.)

I wouldn’t advise this, because the difference is small, and, well, just not worth enough (in my mind) to forgo the pleasure of owning your home free and clear.

Nor would I rush to put much of the money into the stock market, on the assumption you will easily outperform that 4.2% after-tax cost of borrowing.

You should fully fund your 401(k)’s, etc., and a Roth IRA if you qualify for one. If that pinches too much and you need a mortgage, so be it.

Plus, if you’re really confident as an investor and business person, and know the risks, then of course you can throw this advice out the window – 4.2% after tax is a low rate, and, over the long-run, many smart people could do nicely borrowing at that rate and using the proceeds to invest in something else. Or open a Wendy’s – all manner of things.

But a lot of people who try their hands at these things LOSE THEIR MONEY. So I wouldn’t rush into anything at all. One day, there might be a compelling reason to borrow against the house. But until there is, enjoy your prudent good fortune.